Saturday, December 26, 2009

Medtronic/Managing Large Gain In a Bond Position/Bill Tedford's Inflation Prediction & His Sell of TIPs

1. Medtronic (owned): In the follow-up section in this week's Barrons, there is an upbeat assessment of Medtronic's prospects. I do not have access to the report from Credit Suisse referenced in this article, titled "The Sleeping Giant is Awakening". Kristine Stewart, the CS analyst, argues that MDT's new product launches over the next 12 to 18 months will sustain double digit earnings growth. She has a target of $49. I arrived several weeks ago at a target for Medtronic of $49.35, in a manner that would be viewed as simplistic by Wall Street. I took the then current, forward earnings estimate, multiplied it by 15, which seemed reasonable, and came up with $49.35. Item # 6 Added to Medtronic (post dated 9/18/2009). Medtronic was the first stock bought by RB during its March frolic, near the 52 week low at below $26 on 3/4/09. (on 3/6/09, 3/9 & 3/10, the buying began in earnest with buys of NYX, CPB, the TC MJH, the TC PJZ, the TC KSA, DIS, IR, DD, SYY, the TP JWF, KO, the TC JZV, & HNZ). I do not plan to do anything now with my MDT shares. If the price approaches $49, I will make a decision then.

2. Managing Large Unrealized Gains in a Bond Position: One of the hardest decisions to make is whether or not to pare a bond or a preferred stock bought at an extremely favorable price, where the yield at the investor's cost is just phenomenal. What would you do now, assuming you were a reader of this blog, and bought say 2000 shares of AEB, the hybrid from Aegon, at $4.5 earlier in the year? The shares are now trading at over $17. The security pays the greater of 4% or 7/8% above the 3 month LIBOR, calculated on a $25 par value. It is a perpetual security that can be called at Aegon's option after 12/15/2010. It is certainly possible that it will never be called. At the guarantee, the yield at that $4.5 cost is around 22% annually, currently taxed as a qualified dividend for a U.S. taxpayer. If LIBOR rose to 5% during the applicable computation period, the yield would soar to 32.6% annualized. Eight percent 3 month LIBOR would result in a 49.3% annualized yield at that $4.5 cost! It would be hard to give any of those yields up. And, if the investor sold some shares, the proceeds might be invested in another security that would lose value, and almost certainly have a lower yield. I view this issue in a different way for common stocks. If I owned 2000 shares of a common stock that went from $4.5 to $17, I would view it as foolish not to pare or schnitzel as Cramer would say. Booyah Breakdown. It would only be a question of how foolish, measured in part by the size of the position in the portfolio, so that the greater the size-the greater the foolishness. AEB however is a junior bond, which is treated as equity capital for regulatory purposes. And it is a bond paying that buyer at $4.5 a lot to hold onto it. That is the rub. Some of my readers have done better than me with some of these securities. I bought 50 shares of AEB at 4.8 in February, more at $5.5 and at $8. But, I am a tortoise, not a hare, a plodder not a leaper.

Of course, a lot would depend on an individual's particular circumstances, risk tolerance, the size and balance of the overall portfolio, the percentage weight of AEB in that portfolio, and several other factors. There is no cookie cutter answer for this kind of issue. I would start by evaluating Aegon's credit risk. The logical & analytical side wants to know about the risks first and foremost. In assessing those risks, I am not searching for information that confirms my decision to buy the security, or that makes me feel pleased with myself for continuing to own it. I want to search for information that would highlight the risks and identify what can go wrong.

For Aegon, I would have been very focused on the European Commission's burden sharing policy, the long term impact of that policy, and the relevance of the Mandatory Payment events in the AEB prospectus under current circumstances. Those topics are discussed briefly in Aegon Hybrids: Gateway Post and the posts linked therein. Although it is at best an imperfect process, I am trying to evaluate a number of factors to balance risk and reward, the likelihood of a dividend deferral, the consequences of a deferral, and the circumstances that must first exist for a deferral to be legal. After doing that analysis with Aegon, I concluded that I would take the risk of holding all of the Aegon hybrids which I owned, and even added 100 of AEF.

Back to that hypothetical investor holding 2000 of Aegon bought at $4.5. If it was me, and it is not me, I would harvest some of those profits, just in case an unexpected event devastated my unrealized profits. I would generally, though not always, work toward a position of playing with the house's money, taking into account dividends and profits realized on the shares. So, just speaking for myself, I would probably sell 1/3 and keep the rest. I might split that 1/3 into two batches, one to be sold at the beginning of 2010 and another sold at say a couple of bucks higher.

This kind of problem does not lend itself to a right or wrong answer, because the future is unknowable and the yield of the bond at the $4.5 cost is just fantastic. The yield and the nature of the security, being a bond, are the primary impediments to paring the position. Part of the problem is what happens to the funds realized from the pare. The investor could take the funds realized from selling some shares and then buy shares in what turns out to be the next Enron or Lehman, while AEB moves higher and continues paying its quarterly dividend until the investor is long gone. All of this assumes that the investment would be a minimal part of a portfolio. For me, when the value of all securities from a single issuer exceed 1% of my investable portfolio, I am already thinking about paring.

[ I have not sold any of the 350 shares that I own. My total exposure to Aegon hybrids is around $7500 at current prices (far less at cost) and I recently bought 50 shares of the common as a Lottery Ticket. At most I may sell 50 shares of AEB at some point, and I am in no hurry to do that. It is a Rule Violation for me to devote more than $10,000 in initial outlays to the securities of one firm, and that includes bonds, preferred and common stock. ]

Still, and this may be psychological, I would still do a pare of those hypothetical 2000 shares until I became comfortable, moving toward that goal of playing with the house's money, when I am likely to let it ride until something really spooks me about the company. This means that Aegon would have to monitored for as long as I held those AEB shares. After each major event such as an earnings release, I would have to ask myself whether or not I want to continue holding this security, based on an evaluation of the likelihood of continued payments of the dividend. That is why I engaged in often lengthy nerdy discussions of Mandatory Payment Events after the EC announced its burden sharing policy for owners of European hybrid securities like AEB.

I mentioned in an earlier post that I sold LEHPRG, a Lehman equity preferred floater in late 2007, after getting spooked: A RISK OF PREFERRED STOCKS (LEHPRG REMEMBERED) So, once I am spooked, and I view that response as rational under the circumstance, then there would be much more than a pare as a response, either an elimination or a substantial reduction in exposure. We are now near the end of 2009 and HK would horse whip a HT who took another gain this year.

3. Is the Fed Right About Inflation: The Fed keeps saying that inflation is not a problem and it will keep the federal funds rate at 0 to .25% for "an extended period". CPI has already turned up. The cash inflation number, which includes price levels of actual transactions, as opposed to hypothetical ones, is already turning hot. /Agricultural ETFs/What is the Real Cash Inflation Number? A repeat of the 1970s is one possibility given the degree and duration of the fiscal and monetary stimulus on top of the gigantic budget deficits-guns and butter on steroids.

I was interested in an article in the WSJ summarizing the views of Bill Tedford, a bond manager for more than 20 years, who has beaten his benchmark. I had never heard of the guy until I read this article. The model that he has been using to predict inflation is currently signaling CPI accelerating to 3 or 4% by the end of 2010 and hitting 5% to 6% in 2011. This would not surprise me at all. It just seems to me that the government is now repeating the mistakes of the late 1960s and 1970s, and I am having difficulty understanding why the result will be much different.

Tedford sold his TIPs for the same reason that I recently liquidated my entire position in the TIP ETF. /Sold All Shares TIP ETF/Started Hedge for Corporate Bonds This is what I said at the time of that transaction on 11/10/09:

"What precipitated the sell yesterday was that the real yield was falling to about 1.25% on the ten year TIP, the maturity that I use for evaluating the TIP ETF. This ETF has a weighted average maturity of 8.91 years-currently according to its sponsor. iShares Barclays TIPS Bond Fund (TIP): Overview I would not buy a 10 year TIP with a coupon of 1.25%, so I sold the remaining TIP ETF shares that I own a good profit for this kind of investment."

This is the relevant part of my discussion in the gateway post on TIPs:

"Currently the real yield on the 10 TIP is less than 2%. In an inflationary environment, investors may demand more of a real yield for the TIP, and the breakeven point may also increase, in order for the investors to be comfortable that they would actually be receiving a real yield. If there was 6% inflation two years from now, I would expect an older TIP, with a 1.8% real yield and a 1.9% breakeven, to fall in price to make it equivalent to a new TIP offering in real yield and breakeven spread. The accretion to the principal due to the increased inflation may not make up for the fall in price." Advantages and Disadvantages of Treasury Inflation Protected Securities:

That post, like many of the major gateway posts was written over a period of weeks in May and June 2009. Subsequently they were grouped together under a common date, 9/25/2009, so that I could find them more easily.

A few weeks ago, the coupon for the 10 year TIP was barely above 1%. The TIP bonds have fallen in price since late November and the real yield (coupon rate) is back up to 1.43%, better than the 1.25% when I eliminated the TIP ETF, but not yet enticing to me. Government Bonds Why? If inflation increases, the real yield for newly issued TIP securities will rise, as investor demand a higher coupon to compensate for the increased inflation risks. The older TIP bonds would then have to fall in price to equalize the real yield. I agree with that argument. The question for each individual to decide for themselves is how accurate is the market predicting inflation in the pricing of the current TIP.

The recent decline in TIP can be seen looking at the historical prices for the TIP ETF, moving from $106.57 on 11/30 to $103.78 on 12/24. TIP: Historical Prices for ISHARES BARCLAYS TIP

Tedford is apparently telling his clients according to the WSJ to invest in assets that have historically done well in an inflationary environment, such as agricultural commodities, timber, oil and natural gas, and metals.

It goes without saying that many economists do not agree with that assessment. The WSJ article quotes some economists who argue that the velocity of money is more important than the monetary base. The velocity that money is exchanging hands is still down. All of this falls within a category of what I will label as "unknowable". The possibility of inflation becoming a problem has been mentioned as significant enough for me to take proactive measures starting last October, when it was possible to buy assets providing some inflation protection such as floating rate bonds with guarantees at very attractive prices.

I have already started to branch out into agricultural commodities, and have started to increase my common stock position in oil and natural gas firms, with recent buys of 100 shares each in Exxon, Marathon Oil, and Enerplus. I also added IGE at what I viewed as a favorable price a few months ago (BOUGHT 100 IGE at $27.85), and started to increase my holdings in GCS, a CEF investing in natural resource companies. I have also initiated positions in the broader commodity index by buying RJI, and I still own some RJZ for metal exposure. My main metal exposure is gold and silver bullion stored in a lock box.

I would call what I have done to be proactive and sensible until I have more information on which set of experts may be right on the inflation issue. I would describe what I have done is to tilt a little toward accepting Tedford's view. The floaters with guarantees were important in this effort since the purchases were so favorable that they provide now protection in both inflation and deflation (or low inflation) scenarios. The main decision now is for how long do I hold onto some of the fixed coupon bonds with maturity dates ten or more years from now. They will fair poorly if Tedford's inflation forecast comes to pass.

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